Question

Define ratio analysis,What are different types of ratios ,also explain with formulas following ratios:

a)Liquidity Ratios

b)Solvency Ratios

c)Profitability Ratios

Answer 1

Ratio analysis is a quantitative technique of analyzing company's liquidity, operational efficiency, and profitability by studying its financial statements. Rations are financial indicators that provide relevant information about a business entity by quantifying the relationship among selected items on the financial statements

An entity's ratios may be compared with ratio of a different period for that entity. An entity's ratios may also be compared with competitors and industry ratio to evaluate entity performance.

Different types of ratios are, Liquidity Ratios, Efficiency Ratios/Activity ratios, Profitability Ratios, Coverage Ratios/Solvency ratio, Investor ratios/Market Prospect Ratios

Liquidity Ratios : Liquidity ratios are measures of a firm's short term ability to pay maturing short term obligation using the company's current or quick assets.The higher the ratio generally considered, the better for the company's liquidity position. Below are commonly used current ratio

1. Current ratio = Current assets / Current liabilities

2. Quick ratio = Quick assets / Current liabilities

* Quick assets = (Current assets – Inventories - Prepaid expenses). The quick ratio measures a company's ability to meet its short-term obligations with its most liquid assets, it excludes inventories and prepaid expenses from its current assets.

Solvency Ratios/ Coverage ratios : Solvency refers to an entity's capacity to meet its long-term financial obligations. Solvency represent that entity has a positive net worth and a manageable debt. Below are commonly used Solvency ratio

1. Debt to equity = Total debt / Total equity

This ratio indicates the degree of financial leverage being used by the business and includes both short-term and long-term debt. The lower this ratio the better the company's position

2. Total Debt ratio = Total debt / Total assets

This ratio quantifies the percentage of a company's assets that have been financed with debt,

3. Interest coverage ratio = Operating income (EBIT) / Interest expense

EBIT = Earning before Interest expense and taxes

This ratio reflect the ability of a company to cover interest charge. The higher the ratio, the better the company's ability to cover its interest expense.

4. Solvency ratio = (Net Income after taxes + Depreciation + Amortization) / All liabilities

This ratio comparison of profits before non-cash items, divided by all liabilities. A high solvency ratio indicates a better ability to meet the obligations. This ratio is not fully indicative of solvency, at it is based on profits, a higher solvency ratio of a company reflects a higher probability of the company will meet its debt obligations.

Profitability Ratios : These ratios indicate how well a company can generate profits from its operations or resources

1. Profit margin = Net Income / Sales (net)

2. Return of assets = Net Income = Average total assets

3. Return of equity = Net Income = Average total equity

4. Return on sales = EBIT / Net sales

5. Operating cash flow ratio = Cash from operations / current liabilities

Higher the profitability ratios indicate company generate high profits from its operations or available resources